Aftermath Of A Bubble And What Rises From The Ashes

Bubbles are a funny thing. Participants don’t see them. Outsiders shake their heads – until they themselves get sucked in. Central banks support or create them, but deny their existence. Money piles in on top of money. Risks no longer exist. A technological innovation can serve as the logical foundation for unlimited gains. Yet invariably, it leads to mayhem, capital destruction, and devastating consequences for the industry. And a new beginning for the lucky ones. Take natural gas.

Thanks to the Fed’s zero-interest-rate policy and the trillions it has handed to its cronies since late 2008, boundless sums of money went searching for a place to go, and they were chasing yield where there was none, and so they took risks, any kind of risks, in their vain battle to come out ahead, and some of this money found its way to natural gas drilling. It coincided with innovation – the combination of horizontal drilling and hydraulic fracturing that unlocked vast reserves of natural gas in shale formations across much of the US. Result: a debt-fueled drilling bubble.

It ended in a glut that knocked the price of gas from its peak of $13 per million Btu to a 10-year low of $1.92 last April. Short sellers were out in force, predicting with intelligent-looking charts that over-production would fill storage facilities to capacity by early fall. Beyond that, any gas would have to be flared – that is, burned off to light up the night sky. And the price would drop to zero.

In other parts of the world, natural gas was six, seven, and in Japan over eight times more expensive than in the US. One of the most stunning discrepancies in a globalized economy. But the US, the largest producer in the world, has no facilities to export large quantities in form of liquefied natural gas (LNG), though there are pipelines to Mexico (export) and between the US and Canada (import and export). US gas production is essentially landlocked.

It was the darkest hour for natural gas. The industry was ravaged by a price that was far below production costs. Producers wrote off tens of billions of dollars – formalizing the misallocation and destruction of capital that Fed binges entail. They dumped assets to keep their heads above water. They shifted from drilling for “dry” gas to wells whose mix contained larger portions of oil and natural-gas liquids, which sold for higher prices and made wells profitable.

Production leveled off. Power companies switched from coal to gas. The San Onofre nuclear power plant in Southern California was shut down in January 2012 due to a radioactive steam leak and remains off line. Gas-fired power generators had to fill the hole. Other nuclear power plants were taken off line as well. And then there was a winter that turned out to be average, rather than warm. The Gods were starting to smile on natural gas.

But the bloodletting continued this year. Aubrey McClendon, CEO of Chesapeake Energy, the number two producer behind Exxon, was axed. On April 1, GMX, an Oklahoma City oil and gas producer, filed for Chapter 11 bankruptcy protection. It cited the low price of natural gas – which, by that time, had already more than doubled to about $4/mmBtu but was still not high enough for the company to survive intact.

The low price put pressure on drillers to innovate to bring down the cost of production. And they did; now there is pad drilling, for example. Environmental issues will be dealt with: the other option being mountaintop mining and burning more coal! As drilling has become more efficient, they’re drilling less: rig count plunged from 936 in October 2011 to 379 this week. Companies around the world have invested in US oil and gas fields to gain fracking expertise – which they’ll use around the world.

On Thursday, the Energy Information Agency reported that natural gas in underground storage, the primary indicator of over- or underproduction – a horror chart in late 2011 and early 2012 – had dropped 4.2% below the 5-year average and 31.8% below the level of the same week last year. Another step in a year-long trend of demand exceeding supply. Natural gas jumped 4.4% and closed at $4.40/mmBtu. Up 129% from its low a year ago.

Where to, from here? The price of natural gas is as volatile as the gas itself. It can crash because the weather isn’t right. It can spike because of shortages, real or imagined. Spikes occur regularly in regional markets where supply constraints during cold waves can multiply prices at local trading hubs by a factor 5 or even 10 in no time. As the price has risen to where coal is competitive again, natural-gas use for power generation has declined from last year’s phenomenal record, but is still significantly above the 2007-2011 range (EIA graph). Industrial demand is up. And everyone is still waiting for production to actually drop – the new version of the play, Waiting for Godot, who never arrives!

The big question: what is the cost of production of dry natural gas over the life of the well? Only estimates exist, every well is different, and all producers have their own calculus. But Christophe de Margerie, CEO of French mega-oil company Total, which is involved in shale gas projects in Texas and Ohio, let it slip that his company would not restart production of dry gas until the price reached the breakeven point. And then he disclosed what that point was – a crucial marker of where the price of gas might be headed. Read…. Natural Gas “Glut” Is Officially VERY Over.

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